Let us not take our eyes off fiscal policy in Europe

My co-blogger, Christoph Rosenberg, recently wrote an interesting piece on fiscal policy developments in Eastern Europe (“Let’s Not Take our Eyes off Fiscal Policy in Eastern Europe”, Nov 6, 2007). Christoph makes an important distinction between the Central European countries with inflation targets on the one hand and the Baltic countries and Bulgaria with fixed exchange rates on the other hand. Still, he concludes that politicians in both regions have been complacent and not utilised the current upswing to tighten budgets sufficiently.

There may be some merit to the latter viewpoint, but the picture is not clear-cut. First, the trend growth rate of the Eastern European countries appears to be relatively high and has probably increased after the countries joined the EU. If the future is bright and prosperous, then intertemporal smoothing may suggest that the government should borrow now and pay back later – essentially the behaviour favoured by the private sector in most Eastern European countries. Second, many of the Eastern European countries still have inadequate education systems and miserable infrastructure as a carry over from communist times. The returns to such public investments might be quite high.

Third, and the main topic of this piece, I am not sure that the cyclical response of fiscal policy in the Eastern European EU countries is any worse than in the Western European countries. On the contrary, based on panel data estimations for the period 1995-2005 I am convinced that the cyclical fiscal policy response has been much more sensible in Eastern Europe than in Western Europe. It might not be good enough in the East, but it is probably worse in the West.

In the paper I estimated standard fiscal policy reaction functions, where the fiscal balance in one year was explained by the fiscal balance the previous year (inertia), GDP growth (cyclical response) and the public debt stock. I used annual data for the period 1995-2005, which is too short to estimate individual reaction functions for each country. Instead I pooled the data for the Western European countries and for the Eastern European countries based on the argument (and subsequent testing) that the countries within each of the two country groups have gone through rather similar developments.

The striking result is that for the sample period 1995-2005, the fiscal balance exhibits less inertia and is much more counter-cyclical for the group of Eastern European countries than for the group of West European countries. (For both groups, the overall budget balance is not affected by the public debt stock.) Taking literally, these results suggest that the fiscal policy response to cyclical fluctuations has been more coherent in Eastern Europe than in Western Europe. Furthermore, the lack of policy inertia in Eastern Europe indicates that discretionary policy changes have been easier to undertake in this region than in Western Europe. The main differences in the cyclical response seem to arise from the revenue side of fiscal policy. The Western European countries have pursued pro-cyclical revenue policies, while the Eastern European countries have raised revenue in a counter-cyclical or a-cyclical fashion. Differences in the formation of fiscal policy between the two regions may have decreased over time, but this result is very uncertain due to a lack of data points.

In conclusion, fiscal policy formation in Eastern Europe is certainly not “perfect”, but it is unlikely to be any worse than in Western Europe. This result should not lead to complacency, but may suggest that fiscal policy should be under scrutiny in both Eastern and Western EU countries – hence the title of this blog piece.

4 Responses to "Let us not take our eyes off fiscal policy in Europe"

Ulrich Fritsche November 8, 2007 at 11:31 am

That e.g. EMU countries show less counter-cyclicality does not surprise at all, since in some countries EMU under Maastricht led even to pro-cyclicality. It would be interesting to know how Eastern Europe would react under completely fixed rates, no monetary policy anymore and Maastricht ceilings.

Karsten Staehr November 8, 2007 at 2:54 pm

To Ulrich Fritsche: Yes, you are right that the counter- or a-cyclicality of fiscal policy in the EMU countries is known from other studies. The contribution of my paper is to examine the fiscal policy response in Eastern Europe and compare it with the response in Western Europe. The surprise is then that fiscal policy in Eastern Europe is generally quite strongly counter-cyclical. I tried to split the Eastern European countries into the Baltics and Slovenia versus the other countries, and the policy responses were quite similar across the two regions. I think your suggestion of splitting the East European countries based on their exchange rate regime is an excellent idea which I will pursue shortly. Karsten Staehr

Christoph Rosenberg November 9, 2007 at 8:34 am

Karsten:Thanks for drawing my attention to your interesting work on East vs. West Europe. It does put things into perspective…On your second point, I of course agree that there is a need for public investment in the new member staes. But this doesn’t necessarily have to translate into higher deficits. Germany ran a pretty tight fiscal policy in the 1960s and still built a word-class infrastructure–without the help of EU funds. These countries need to look at current spending, as Slovakia did a few years ago.X-toph